CHAPTER 4 CONCEPTUAL FRAMEWORK

Elements of financial statements

TECHNICAL KNOWLEDGE

To identify the elements directly related to the measurement of financial position and financial
performance.

To understand the concept of asset, liability and equity.

To understand the concept of income and expenses.

To know the requirements for the recognition of the elements of financial statements.

To be aware of the various financial attributes for measuring the elements of financial
statements.

Elements of financial statements

Financial statements portray the financial effects of transactions and other events by grouping
them into broad classes according to their economic characteristics.

These broad classes are termed the elements of financial statements.

The elements of financial statements refer to the quantitative information reported in the
statement of financial position and income statement.

The elements of financial statements are the "building blocks" from which financial statements
are constructed.

The presentation of these elements in the statement of financial position and the income
statement involves a process of classification sub classification.

For example, assets and liabilities may be classified by their nature or function in the business
of the entity in order to display information in a manner most useful to users for purposes of
making economic decisions.

The elements directly related to the measurement of financial position are:

a. Asset

b. Liability

c. Equity

The elements directly related to the measurement of financial performance are:

a. Income

b. Expense

The Conceptual Framework identifies no elements that are unique to the statement of changes
in equity because such statement comprises items that appear in the statement of financial
position and the income statement.
Equity is the residual interest in the assets of the entity after deducting all of the liabilities.

RECOGNITION OF ELEMENTS

Recognition is a term which means the reporting of an asset, liability, income or expense on
the face of the financial statements of an entity.

There are four main recognition principles to be followed in the preparation and presentation
of financial statements, as explicitly enumerated in the Conceptual Framework, namely:

a. Asset recognition principle

b. Liability recognition principle

c. Income recognition principle

d. Expense recognition principle

Asset recognition principle

Old Conceptual Framework: An asset is defined as a resource controlled by the entity as a

result of past events and from which future economic benefits are expected to flow to the
entity

Revised Conceptual Framework: An asset is defined as a present economic resource

controlled by the entity as a result of past events. An economic resource is a right that has
the potential to produce economic benefits.

Main changes in the definition of an asset:

• separate definition of an economic resource—to clarify that an asset is the economic

resource, not the ultimate inflow of economic benefits
• deletion of ‘expected flow’—it does not need to be certain, or even likely, that economic
benefits will arise
• a low probability of economic benefits might affect recognition decisions and the
measurement of the asset

An asset is recognized when it is probable that future economic benefits will flow to the entity
and the asset has a cost or value that can be measured reliably.

Thus, two conditions must be present for the recognition of an asset:

a. It is probable that future economic benefits will flow to the entity.

The term "probable" means that the chance of the future economic benefit arising is more
likely rather than less likely.

b. The cost or value of the asset can be measured reliably.

Future economic benefit

The future economic benefit embodied in an asset is the potential to contribute directly or
indirectly to the flow of cash and cash equivalents to the entity.

The potential may be a productive one that is part of the operating activities of the entity.

It may also take the form of convertibility into cash or cash equivalents or a capability to
reduce cash outflows, such as when an alternative manufacturing process lowers the costs of
production.

The future economic benefit embodied in an asset may flow to the entity in a number of ways,
for example, by being:

a. Used singly or in combination with other assets in the production of goods or services to
be sold by the entity.

b. Exchanged for other assets.

c. Used to settle a liability..

d. Distributed to the owners of the entity.

Cost principle

Inherent in asset recognition is the cost principle.

The cost principle requires that assets should be recorded initially at original acquisition cost.

This initial cost may be carried without change, may be changed by depreciation, amortization
or write-off, or may be shifted to other categories as in the case of raw materials being
converted into finished goods.

But the question is how much is cost?

In a cash transaction, cost is equivalent to the cash payment.

In a noncash or an exchange transaction, the cost is equal to the fair value of the asset given
or fair value of the asset received, whichever is clearly evident.

In the absence of fair value, the cost is equal to the carrying amount of the asset given.

Liability recognition principle

Old Conceptual Framework: A liability is defined as a present obligation arising from past
events the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits.

Revised Conceptual Framework: A present obligation of the entity to transfer an economic

resource as a result of past events. An obligation is a duty or responsibility that the entity
has no practical ability to avoid.
Main changes in the definition of a liability:

• separate definition of an economic resource—to clarify that a liability is the obligation to transfer the
economic resource, not the ultimate outflow of economic benefits
• deletion of ‘expected flow’—with the same implications as set out above for an asset
• introduction of the ‘no practical ability to avoid’ criterion to the definition of obligation

No practical ability to avoid

The revised Conceptual Framework discusses how the ‘no practical ability to avoid’ criterion
is applied in the following circumstances:

1. (a) if a duty or responsibility arises from the entity’s customary practices, published
policies or specific statements—the entity has an obligation if it has no practical
ability to act in a manner inconsistent with those practices, policies or statements.
2. (b) if a duty or responsibility is conditional on a particular future action that the
entity itself may take—the entity has an obligation if it has no practical ability to
avoid taking that action.

A liability is recognized when it is probable that an outflow of resources embodying economic

benefits will be required for the settlement of a present obligation and the amount of the
obligation can be measured reliably.

Thus, two conditions must be present for the recognition of a liability:

a. It is probable that an outflow of economic benefits will be required for the settlement of a
present obligation.

b. The amount of obligation can be measured reliably.

Liabilities

An essential characteristic of a liability is that the entity has a present obligation which may
be legal or constructive.

Obligations may be legally enforceable as a consequence of a binding contract or statutory

requirement.

This is normally the case, for example, with accounts payable for goods and services received.

Constructive obligations arise from normal business practice, custom and a desire to maintain
good business relations or act in an equitable manner.

For example, an entity decides as a matter of policy to rectify faults in the products even
when these become apparent after the warranty period.

Settlement of liability

Settlement of a present obligation may occur in a number of ways, for example, by:

a. Payment of cash

b. Transfer of noncash assets

c. Provision of services

d. Replacement of the obligation with another obligation

e. Conversion of the obligation into equityс.

Definition of income

Income is increase in economic benefit during the accounting period in the form of inflow or
increase in asset or decrease in liability that results in increase in equity, other than
contribution from equity participants.

The definition of income encompasses both revenue and gains.

Revenue arises in the course of the ordinary regular activities and is referred to by a variety
of different names including sales, fees, interest, dividends, royalties and rent.

The essence of revenue is regularity.

Gains represent other items that meet the definition of income and do not arise in the course
of the ordinary regular activities.

For example, gains include gain from disposal of noncurrent assets, unrealized gain on trading
securities and gain from expropriation.

Income recognition principle

The basic principle is that income shall be recognized when earned.

But the question is when is income considered to be earned?

The Conceptual Framework provides that income is recognized when it is probable that an
increase in future economic benefits related to an increase in an asset or a decrease in a
liability has arisen and that the increase in economic benefits can be measured reliably.

Thus, two conditions must be present for the recognition of income, namely:

a. It is probable that future economic benefits will flow to the entity as a result of an increase
in an asset or a decrease in a liability.

b. The economic benefits can be measured reliably.

Point of sale

Undoubtedly, the two conditions for income recognition are present at the point of sale.
Accordingly, the point of sale is the point of income recognition.
The reason is that it is at the point of sale that the entity has transferred to the buyer the
significant risks and rewards of ownership of the goods.

Stated differently, legal title to the goods passes to the buyer at the point of sale.

Incidentally, the point of sale is usually the point of delivery, which may be actual or
constructive.

Legally, it is delivery that transfers ownership from the seller to the buyer.

Exceptions to the point of sale

Under certain conditions, the following methods are applied in recognizing income:

a. Installment method - Revenue is recognized at the point of collection.

The amount of revenue is determined by multiplying the gross profit rate by the amount of
collections.

b. Cost recovery method or sunk cost method – Revenue is recognized also at the point of
collection.

However, unlike the installment method, all collections are first applied to the cost of the
merchandise sold.

c. Percentage of completion method – Contract revenue and contract costs associated with
the construction contract shall be recognized as revenue and expenses, respectively, by
reference to the stage of completion of the contract activity.

d. Production method – Revenue is recognized at the point of production.

The production method is applicable to agricultural, forest and mineral products.

The installment method, cost recovery method and percentage of completion method are
taken more in detail in an advanced accounting course.

Other income recognition

Interest revenue shall be recognized on a time proportion basis that takes into account the
effective yield on the asset.

Royalties shall be recognized on an accrual basis in accordance with the substance of the
relevant agreement.

Dividends shall be recognized as revenue when the shareholder's right to receive payment is
established, meaning, when the dividends are declared.

Installation fees are recognized as revenue over the period of installation by reference to the
stage of completion.

Subscription revenue should be recognized on a straight line basis over the subscription
period.

Admission fees are recognized as revenue when the event takes place.

Tuition fees are recognized as revenue over the period in which tuition is provided.
Definition of expense

Expense is decrease in economic benefit during the accounting period in the form of an outflow
or decrease in asset or increase in liability that results in decrease in equity, other than
distribution to equity participants.

Expenses encompass losses as well as those expenses that arise in the course of the ordináry
regular activities.

Expenses that arise in the course of ordinary regular activities include, for example, cost of
sales, wages and depreciation.

Losses do not arise in the course of the ordinary regular activities and include losses resulting
from disasters.

Examples include losses from fire, flood, storm surge, tsunami and hurricane, as well as those
arising from disposal of noncurrent assets.

Expense recognition principle

The basic expense recognition principle means that "expenses are recognized when incurred".

But the question is when are expenses incurred?

The Conceptual Framework provides that expenses are recognized when it is probable that a
decrease in future economic benefits related to decrease in an asset or an increase in liability
has occurred and that the decrease in economic benefits can be measured reliably.

Thus, two conditions must be present for the recognition of expenses:

a. It is probable that a decrease in future economic benefits has occurred as a result of a

decrease in an asset or an increase in a liability.

b. The decrease in economic benefits can be measured reliably.

Matching principle

Actually, the expense recognition principle is the application of the matching principle.

The generation of revenue is not without any cost. There has got to be some cost in earning
a revenue.

"There is no gain if there is no pain".

The matching principle requires that those costs and expenses incurred in earning a revenue
shall be reported in the same period.

The matching principle has three applications, namely:

a. Cause and effect association

b. Systematic and rational allocation

c. Immediate recognition

Cause and effect association

Under this principle, the expense is recognized when the revenue is already recognized.

The reason is the presumed direct association of the expense with specific items of income
This is actually the "strict matching concept".

This process, commonly referred to as the matching of cost with revenue, involves the
simultaneous or combined recognition of revenue and expenses that result directly and jointly
from the same transactions or events.

The best example is the cost of merchandise inventory.

Such cost is considered as an asset in the meantime that the merchandise is on hand.

When the merchandise is sold, the cost thereof is expensed in the form of "cost of goods sold"
because at such time revenue may be recognized.

Other examples include doubtful accounts, warranty expense and sales commissions.

Systematic and rational allocation

Under this principle, some costs are expensed by simply allocating them over the periods
benefited.

The reason for this principle is that the cost incurred will benefit future periods and that there
is an absence of a direct or clear association of the expense with specific revenue.

When economic benefits are expected to arise over several accounting periods and the
association with income can only be broadly or indirectly determined, expenses are recognized
on the basis of systematic and allocation procedures.

Concrete examples include depreciation of property, plant and equipment, amortization of

intangibles, and allocation of prepaid rent, insurance and other prepayments.

Immediate recognition

Under this principle, the cost incurred is expensed outright because of uncertainty of future
economic benefits or difficulty of reliably associating certain costs with future revenue.

An expense is recognized immediately:

a. When an expenditure produces no future economic benefit.

b. When cost incurred does not qualify or ceases to qualify for recognition as an asset.

Examples include officers' salaries and most administrative expenses, advertising and most
selling expenses, amount to settle lawsuit and worthless intangibles.

Many losses, such as loss from disposal of building, loss from sale of investments, and casualty
loss, are immediately recognized because they are not directly related to specific revenue.
Measurement of elements

Measurement is the process of determining the monetary amounts at which the elements of
the financial statements are to be recognized and carried in the statement of financial position
and income statement.

There are four measurement bases or financial attributes, namely:

a. Historical cost

b. Current cost

c. Realizable value

d. Present value

Definition of terms

a. Historical cost is the amount of cash or cash equivalent paid or the fair value of the
consideration given to acquire an asset at the time of acquisition.

This is also known as "past purchase exchange price".

Historical cost is the measurement basis most commonly adopted in preparing the financial
statements.

b. Current cost is the amount of cash or cash equivalent that would have to be paid if the
same or equivalent asset was acquired currently.

This is also known as "current purchase exchange price".

c. Realizable value is the amount of cash or cash equivalent that could currently be obtained
by selling the asset in an orderly disposal.

This is also known as "current sale exchange price".

d. Present value is the discounted value of the future net cash inflows that the asset is
expected to generate in the normal course of business.

This is also known as "future exchange price".